No Gain from Reducing G-3 Currency Volatility

A policy that seeks to limit currency fluctuations could end up fostering more instability in emerging markets because it relies so heavily on swapping exchange rate uncertainties for interest rate uncertainties.

As many developing countries have tied their currencies to the U.S. dollar (in varying degrees), some analysts believe that exchange rate volatility among industrialized nations is at least partially to blame for the financial crises that plague emerging markets. Those analysts argue that the Group of 3-- the United States, Japan, and collectively the 12 nations that have adopted the Euro -- could reduce such shocks on dollar pegs or quasi-pegs in emerging markets by adjusting interest rates so that their currencies trade within certain "target zones."

But when co-authors Carmen Reinhart and Vincent Reinhart examine almost 30 years of capital flows, currency valuations, interest rate shifts, and economic growth in both emerging and industrialized nations, they uncover no evidence that limiting exchange rate volatility among the G-3 would provide significant benefits for emerging markets. In What Hurts Most? G-3 Exchange Rate Or Interest Rate Volatility? (NBER Working Paper No. 8535) they find "no obvious bonuses to smaller countries should G-3 central banks damp the fluctuations of their currencies" and it could possibly hurt.

In this vein, the authors note that a policy that seeks to limit currency fluctuations could end up fostering more instability in emerging markets because it relies so heavily on swapping exchange rate uncertainties for interest rate uncertainties. The authors do not deny that exchange rates are an important part of the relationship between developed countries in the "North" and emerging markets in the "South," where governments often show a commitment to low inflation by tying their currencies to the dollar. And they acknowledge that, historically, financial crises have "been more frequent when G-3 exchange rates are more volatile." But they note that the situation is not that simple. They argue that a closer look at how money flows to emerging markets--for example, foreign direct investment tends to be higher in times of currency instability among the G-3 -- shows that over the past 27 years, buying exchange rate predictability among the G-3 with greater uncertainty in international interest rates "would have been a bad bet."

Reinhart and Reinhart agree that keeping G-3 exchange rates in target zones could indeed lead to more stable prices in emerging markets. However, they point out that the effect on interest rates could make debt-servicing costs much more unpredictable, while producing "income volatility" in developed countries that could decrease demand for emerging market exports. "To the extent that high world interest rates trigger balance sheet problems in emerging markets, the consequences of the tradeoff implied by a target zone among G-3 currencies may be considerable," the authors write. The important thing to bear in mind, according to Reinhart and Reinhart, is that the relationship between developed and emerging economies is a complex one and focusing on a single issue or set of issues cannot capture their interdependence.

"The consequences for the developing 'South' of interest rate, exchange rate, and income volatility in the 'North' are only one particular aspect of myriad North-South links," they write. "As such, issues related to G-3 exchange rate variability should be viewed within the much larger panorama of how economic outcomes in developed countries influence those in less developed economies."

-- Matthew Davis